Econ 252 Spring 2011 Problem Set 6 Solution

Econ 252 Spring 2011
Econ 252 - Financial Markets Spring 2011 Professor Robert Shiller Problem Set 6 Solution
Problem Set 6 Solution
Professor Robert Shiller
Question 1 (a) A futures contract is an obligation to trade at a future date at a price specified in the contract, and an options contract is a right, but not an obligation, to trade at a against symmetric risk and options to protect against asymmetric risk. future date at a price specified in the contract. Investors use futures to protect (b) The correct answer is the second alternative. The farmer should sell futures make exactly $140,000 and pay back his loan.
contracts for 20,000 bushels with a futures price of $7 and delivery in 3 months.
He then can sell at $7, no matter what the market price is. Therefore, he can If he purchases those futures contracts, then the futures contract obligates him to purchase corn in 3 months, which he does not need. If he buys put options with a strike price of $2, he obtains the right to sell the corn at $2 per bushel, and this would not be enough to cover his debt.
(c) The correct answer is the third alternative. Because the manager believes that with a strike price of $30 maturity maturing in 6 months.
the stock price will down to $25 in 6 months, he would like to place a bet
reflecting this pessimistic outlook. So, the manager should purchase put options If the investor purchases the call option from the first alternative, and the stock then he gains if the spot price is higher than $30 six months from now, but he for him. price falls below $30, the option will be out of the money, and he might end up with a negative profit. If he purchases the future from the second alternative, incurs a loss if the stock price falls below $30. As he believes that stock price will
go down to $25 in 6 months, neither this call nor this future will be appropriate
Question 2
(a) The payoff of the described call option at maturity is as follows: Underlying ST40 0 ST>40 ST-40 Payoff Call C1 with E=40
The cost of the call option is $8. It follows that the profit of the described call option at maturity is as follows: Underlying ST40 -8 ST>40 ST-48 Profit Call C1 with E=40
(b) The payoff of the described put option at maturity is as follows: Underlying ST40 40-ST ST>40 0 Payoff Put P1 with E=40
The cost of the put option is $12. It follows that the profit of the described put option at maturity is as follows: Underlying ST40 28-ST ST>40 -12 Profit Put P1 with E=40
(c) The payoff of the described portfolio at maturity is obtained as follows: Underlying ST40 0 ST>40 ST-40 ST-40 0 Payoff Call C1 with E=40 Payoff Put P1 with E=40 Payoff Portfolio C1+P1
40-ST 40-ST
The portfolio C1+P1 costs $8+$12=$20. It follows that the profit of the portfolio at maturity is as follows: Underlying ST40 20-ST ST>40 ST-60 Profit Portfolio C1+P1
An investor might want to construct this portfolio if he thinks that the stock will without knowing in which direction the stock will move.
move substantially between the time of construction and the maturity date,
(d) The payoff of the described portfolio at maturity is obtained as follows: Underlying ST40 0 0 0 40<ST50 ST-40 ST-40 0 ST>50 ST-40 ST-50 10 Payoff Call C1 with E=40 Payoff Call C2 with E=50 Payoff Portfolio C1-C2
The portfolio C1-C2 costs $8-$5=$3. It follows that the profit of the portfolio at maturity is as follows: Underlying ST40 -3 40<ST50 ST-43 ST>50 7 Profit Portfolio C1-C2
An investor might want to construct this portfolio if he thinks that the price of the stock will go up moderately between the time of construction and the maturity date. Moreover, he puts a limit on his losses if the stock decreases.
(e) The payoff and the profit of the described portfolio are as follows: Underlying ST40 0 0 0 0 40<ST45 ST-40 0 0 45<ST50 ST-40 ST-45 50-ST 0 Payoff Call C1 with E=40 Payoff Call C2 with E=50 Payoff Call C3 with E=45 Payoff Portfolio C1+C2-2C3
Professor Robert Shiller ST>50 ST-40 ST-50 ST-45 0
ST-40
The portfolio C1+C2-2C3 costs $8+$5-2$6=$1. It follows that the profit of the portfolio is as follows: Underlying Profit Portfolio C1+C2-2C3 ST40 -1 40<ST45 ST-41 45<ST50 49-ST ST>50 -1
An investor might want to construct this portfolio if he wants to bet that that the stock falls within a certain interval of prices at the maturity date. At the same, the investors losses are limited if the stock falls outside the interval that the investor aims for.
Question 3
The price of the underlying XYZ evolves as follows: A year from now: S ( u) = u S (0) = 150, S ( d ) = d S (0) = 50. Two years from now:
S ( uu) = u 2 S (0) = 225, S ( ud ) = S ( du) = u d S (0) = 75, S ( dd ) = d 2 S (0) = 25.
(a) The one-period Binomial Asset Pricing Model has the following schematic form:
The one-period hedge ratio for the call option C1 is H=
C ( u) C ( d ) max[150 30,0] max[50 30,0] H= = 1. ( u d ) S (0) (1.5 0.5) 100
The hedge ratio denotes the number of stocks you want to hold per option sold in order to construct a hedge portfolio, which generates the same payoffs in each state of the world. This means that the hedge portfolio is riskless. Therefore, an investor has two possibilities to transfer money from period 0 to period 1, the hedge portfolio and investing at the risk-free rate. It then follows from the no-arbitrage principle that these two possibilities must must equal r. Knowing the value of the hedge portfolio in a subsequent period and the return of the hedge portfolio therefore determines the value of the call option today.
have the same return, i.e. the rate of return for investing in the hedge portfolio
(b) The desired quantity is C1(0), which satisfies the following identity: H S ( u) C1 ( u) 1 150 max[150 30,0] = 1+ r = 1.25 H S (0) C1 (0) 1 100 C1 (0) C1 (0) = 76.
(c) The one-period Binomial Asset Pricing Model has the following schematic form:
The desired quantity C2(0) will be obtained via backward induction. At the upper node in period 1, that is, after the stock price increases once: H ( u) = C2 ( uu) C2 ( ud ) max[225 30,0] max[75 30,0] H ( u) = = 1. ( u d ) S ( u) (1.5 0.5) 150
identity:
Furthermore, the price of C2 at the upper node in period 1 satisfies the following H S ( uu) C2 ( uu) 1 225 max[225 30,0] = 1+ r = 1.25 H S ( u) C2 ( u) 1 150 C2 ( u) C2 ( u) = 126.
At the bottom node in period 1, that is, after the stock price increases once: H ( d) =
C2 ( du) C2 ( dd ) max[75 30,0] max[25 30,0] H (d ) = = 0.9. ( u d ) S ( d ) (1.5 0.5) 50
Furthermore, the price of C2 at the bottom node in period 1 satisfies the following identity: H S ( du) C2 ( du) 0.9 75 max[75 30,0] = 1+ r = 1.25 H S ( d ) C2 ( d ) 0.9 50 C2 ( d ) C2 ( d ) = 27.
Hence, C2(d)=$27 is the answer to the first question. Finally, at the initial node: H (0) = C2 ( u) C2 ( d ) 126 27 H (0) = = 0.99. ( u d ) S (0) (1.5 0.5) 100
Furthermore, the price of C2 at the initial node satisfies the following identity: H S ( u) C2 ( u) 0.99 150 126 = 1+ r = 1.25 H S (0) C2 (0) 0.99 100 C2 (0) C2 (0) = 81.
Hence, C2(0)=$81 is the answer to the second question. (d) The price of the call-option has increased from $76 to $81, as the maturity of the call option has increased from one year to two years. This result is intuitive for
call options, as a call-option becomes more valuable for higher stock prices.
When the maturity becomes longer, the range of possible prices for the stock value of the call option.
increases. The strike price of the call option however cuts off the bottom part
of this range, leaving only the higher range of the stock price. This benefits the
(e) Recall that the put-call parity is
Problem Set 6 Solution C+ E = S + P, (1 + r)T
the stock price evolution.
where T denotes time to maturity. It holds at any time period and for any state of
Therefore, the price of a 2-year put with the same strike price as C2 a year from now after the price has gone down once is 27 + 30 = 50 + P ( d ) P ( d ) = 1. 1 + 0.25
Analogously, the price of this put option today is: 81 +
30 = 100 + P (0) P (0) = 0.2. (1 + 0.25) 2
Question 4
The Black-Scholes formula is
C = S N ( d1 ) e rT E N ( d2 ), S 2 T ln + r T + E 2 d1 = , T S 2 T ln + r T E 2 d1 = . T
where d1 and d2 are defined as follows:
The notation is hereby as follows:
C is the current price of a European call option written on a stock with strike price E and time to maturity T,
r is the risk-free interest rate,
S is the current price of the underlying stock, is the standard deviation of the return on the underlying stock,
N is the cumulative normal distribution function.
(a) According to the information given, it follows that
S 200 2 T (0.5) 2 4 ln + r T + ln + 0.2 4 + E 120 2 2 d1 = = 1.8108, T 0.5 4 S 200 2 T (0.5) 2 4 ln + r T ln + 0.2 4 E 120 2 2 d2 = = 0.8108. T 0.5 4
Hence, the price of the desired call-option is given by
C = S N ( d1 ) e rT E N ( d2 ) 200 N (1.8108) e 0.24 120 N (0.8108) 150.31.
(b) Recall that the put-call parity is
Problem Set 6 Solution C + e rT E = S + P,
where the only new variable is P, which denotes the price of a put option that has the same underlying, the same strike price, and the same time to maturity as the call-option whose current price is denoted by C. in part (a) is Therefore, the price of a 4-year put with the same strike price as the call option 150.31 + e 0.24 120 = 200 + P P 4.23.
(c) According to the information given, it follows that
C = S N ( d1 ) e rT E N ( d2 ) 200 N (2.0385) e 0.24 120 N (1.2385) 147.75.
price as the call option above is
According to the put-call parity, the price of a 4-year put with the same strike 147.75 + e 0.24 120 = 200 + P P 1.67.
Both the price of the call and the put option decreases in response to a decrease of the volatility of the underlying stock. First, consider the call option. It becomes more valuable for higher stock prices and cuts off stock prices below the strike price. Therefore, as stock prices are less far apart because of the lower volatility, the call option becomes less valuable. and cuts off stock prices above the strike price. Therefore, as stock prices are valuable.
Second, consider the put option. It becomes more valuable for lower stock prices less far apart because of the lower volatility, the put option also becomes less
(d) According to the information given, it follows that
C = S N ( d1 ) e rT E N ( d2 ) 200 N (1.9931) e 0.24 100 N (0.9931) 157.65.
price as the call option above is
According to the put-call parity, the price of a 4-year put with the same strike 157.65 + e 0.24 100 = 200 + P P 2.58.
The price of the call increases in response to the decrease in the strike price. In contrast, the price of the put option decreases in response to the decrease in the strike price. and cuts off stock prices below the strike price. The decrease in the strike price increases the value of the option for higher stock prices. therefore decreases the region for which the option cuts off the stock price and First, consider the call option. It becomes more valuable for higher stock prices
Second, consider the put option. It becomes more valuable for lower stock prices and cuts off stock prices above the strike price. The decrease in the strike price decreases the value of the option for lower stock prices. therefore increases the region for which the option cuts off the stock price and

Econ 252 Spring 2011 Problem Set 6 Solution

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Econ 252 Spring 2011 Problem Set 6 Solution

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Econ 252 Spring 2011

Problem Set 6 Solution

Professor Robert Shiller